Starting and running your own business is not easy. When it comes to important decisions, many business owners strive for the simplest option. This is why sole proprietorships are the most popular type of business entity in the US. Unlike corporations and limited liability companies (LLC), it is extremely easy to legally establish a sole proprietorship. But that doesn’t mean sole proprietorships have no disadvantages. In this guide, we’ll explain what a sole proprietorship is, how to set up a sole proprietorship, and the pros and cons of choosing this over another business entity.
What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business that is owned and operated by one person or a married couple. Business income and losses are reported on the sole proprietor’s personal tax returns. Sole proprietors are legally responsible for the business’s debts and liabilities.
The only documentation you need to open a sole proprietorship are the business permits and licenses required by your home state and local government. You don’t, however, have to legally register your business with your home state. So, if you (or you and your spouse) open a business with no business partners and have not registered with your home state, your business is categorized as a sole proprietorship. Yes, it’s really that easy.
What kinds of businesses are Sole Proprietorships?
Odds are, you’ve encountered or done business with a sole proprietor at least once. The most common example is a freelancer like a journalist or graphic designer. Most home-based businesses are sole proprietors. Other examples include personal trainers, accountants, or consultants. All these individuals had to do was look up what kind of permits and licenses are required by their city and state in order to sell their products or services. Once they began offering these products or services, their business was technically open.
What are the advantages of a Sole Proprietorship?
- Less Paperwork
Aside from the aforementioned permits or licenses, the only other legal documentation you may need to start a sole proprietorship is what’s known as a “DBA,” which stands for “Doing Business As.” A DBA is required by any business (regardless of entity) that intends to operate under a name other than the full name of the owner. Sole proprietors often don’t have to worry about filing a DBA because even though they are technically business owners, their businesses don’t have names. That personal trainer or graphic designer you hired is probably just referred to by the individual’s name, and doesn’t market him or herself in any other way.
But if someone named Steven Clark wanted to open a restaurant named “Steven’s Pasta,” that individual would likely have to file a DBA. Without a DBA, Steven would only be able to market his restaurant using his full name. Even putting up an awning on the building that says “Steven’s Pasta” would technically be considered fraud.
So, sole proprietors need only the required permits or licenses and a DBA. Owners of corporations or LLCs, on the other hand, must continuously store and file additional paperwork, or else they will lose their legal status.
- Taxes Are Much Less Complicated
Compared to corporations and LLCs, filing taxes as a sole proprietor is very simple. Rather than filing separate business taxes on top of your own taxes, all you have to do is attach a Schedule C to your 1040 tax return. And since the sole proprietor is the only owner, all the after-tax profits go to you, or you and your spouse. Other business entities have to file for an employee identification number and determine how much of the company is owned by each owner.
- No Banking Requirements
Banking is yet another critical element of running a business that is much easier for sole proprietors. This is only type of business entity that does not require a business checking account. You can make and accept business payments through your own bank account, which spares you from the tedious process of setting up business banking. A checking account is the only banking requirement you need to start a sole proprietorship. LLCs are not legally obligated to have a business checking account but this would defeat one of the primary purposes of having an LLC, which is protecting your personal assets.
What are the disadvantages of Sole Proprietorship?
- Unlimited Liability
One of the biggest advantages of being registered as a legal business entity (especially an LLC) is limited personal liability for business-related issues. Owners of LLCs, for example, are not at risk of having their personal assets seized by creditors in the event of a problem with debt.
None of these protections, however, are available for sole proprietors. Creditors can seize your personal assets if you don’t fulfill your obligations or if an employee personally sues the business owner after suffering physical harm at work. The latter scenario can be particularly dangerous for businesses that have an above-average risk of employee injury. If someone were to sue the business to cover medical bills, the court could seize your personal assets in order to meet the plaintiff’s needs because you are a sole proprietor. The owner of another business entity would only have to give up business assets in the event of a successful injury lawsuit.
- Higher Taxes
Sole proprietors are often eligible for significant tax deductions (home business expenses, car expenses, etc) but usually have to pay more taxes than other business entities. The new tax reform law will likely not change this, even though it allows certain sole proprietors to deduct 20% of their business’s net income from their taxes. This is partially because many sole proprietors will not qualify for the full 20% deduction.
In order to qualify for the full deduction as a sole proprietor, you must make under $315,000 as a married couple or under $157,500 as an individual owner. Your industry is a factor as well. Sole proprietors who are categorized as artists, athletes, lawyers, accountants and more will not qualify for the full deduction if they exceed a certain annual income limit.
Another reason sole proprietors tend to pay more taxes overall than corporations or LLC is self-employment taxes like Medicare and Social Security. As a sole proprietor, your income taxes and self-employment taxes are based on your business’s total income. The more money your business makes; the more taxes you pay. Owners of other business entities can make moves to reduce self-employment taxes, like taking money out of the business’s total income as dividends.
As you can see, taxes for sole proprietors are highly subjective. Sole proprietors are therefore recommended to speak to an accountant or tax professional to get a clear picture of how much they’ll have to pay.
- Business Loans Might Be Harder To Obtain
Sole proprietorships reportedly have a harder time being approved for business loans from traditional business lenders like banks. Other business entities are usually larger, older, and more likely to have expensive assets that can be used as collateral. Sole proprietors also usually cannot build extensive business credit because they don’t have business credit cards. And since sole proprietors usually don’t have business accounts, they cannot produce bank statements from business bank accounts to show exactly how much money their business is earning and spending.
Even a more established sole proprietorship might struggle to obtain a business loan because sole proprietors are notoriously busy. They tend to handle various responsibilities on their own, like marketing, business development, or bookkeeping. When you’re this busy, you don’t have the time to shop for different business loans or compile paperwork for applications.
This is why sole proprietors are often advised to seek alternative options for business loans. Companies like United Capital Source frequently work with smaller and/or younger businesses with poor or little credit history. The application process is quick, and unlike banks, these companies aren’t biased towards traditionally successful types of businesses.
Minimizing Disadvantages Of Sole Proprietorship
As you can see, some of the disadvantages of sole proprietorship are not legally enforced. There is no rule that says you can only have one bank account or only use personal credit cards. Opening a business bank account and getting a business credit card can offset the problems sole proprietors sometimes experience with legitimacy, business credit, borrowing funds, and organization.
Acquiring these resources can make sole proprietorship so beneficial that you probably won’t have to think about changing entities until much later on. Many sole proprietors only became LLCs after reaching a major revenue milestone or hiring a certain number of employees. The decision may very well come down to this question: Do you love money more than you hate paperwork? If the answer is yes, then it might be time to leave simplicity behind.